The changing face of aircraft lending

Having emerged battered and bruised from the 2008 recession, aircraft lenders face fresh challenges. While worldwide economic woes linger like a bad cold that won’t go away, these lenders can expect accounting and regulatory changes that may have a significant impact on their business.

The industry is already subject to substantial regulation, much of which requires banks to keep adequate reserves, “know” their customers, better understand international transactions and follow sources and uses of funds. As the business aircraft market becomes increasingly international, such regulations can hinder legitimate transactions. A Forbes 400 client purchasing an airplane from a European bank recently faced the kind of scrutiny normally reserved for convicted felons. But existing regulation is only part of the story. Worries about credit and collateral these days cause lenders to closely scrutinize the recipients of their loans, the models those customers are buying and how much exposure the lender already has to them in other credit facilities.

Regulators share these concerns. In an effort to prevent credit bubbles and resulting financial meltdowns like the one that occurred in 2008, international regulators are working on the so-called Basel III accords, which will likely have a big impact on aircraft loans and the world economy in general. These accords will be the third incarnation of reforms sponsored by the Committee on Banking Supervision of the Bank of International Settlements in Basel, Switzerland.

Two aspects of Basel III seem particularly significant for business aviation.

First, banks will need more capital–lots more. Over the rest of this decade, they will be required to stockpile reserves (primarily equity) equal to two and one half times the current requirement. For “systemically important” banks like Citi, Bank of America and Wells Fargo, the capital requirements will be even greater, in an effort to ensure that institutions that are “too big to fail” in fact don’t.

Second, banks will have to keep more of their capital liquid, to ensure that they can quickly discharge their obligations in an emergency and stay afloat. One of these requirements treats an aircraft loan as a completely illiquid investment, which in turn requires the bank to keep more capital on hand than in the case of other investments such as home mortgage or retail loans, which are more easily sold.

The net impact on business aircraft finance is difficult to gauge, but the situation doesn’t look promising. “Aircraft lending will continue to be available,” said Ford von Weise, who heads up global aircraft finance efforts at Citi Private Bank, “but Basel III will change the risk/return/reward relationships of aircraft finance for banks.” There will be an even greater focus on credit quality, with investment-grade credits benefiting from lower interest-rate spreads and especially favorable terms. Lesser credits, on the other hand, will experience higher interest-rate spreads simply because banks will need higher returns to compensate for the greater capital reserves required as the creditworthiness of the customer declines.

Banks will also greatly prefer financing aircraft for existing clients, since Basel III regards that as less risky than making loans to borrowers who have no relationship to the bank. “This is an advantage for private banks,” said von Weise, “since their mission is to develop relationships with clients and offer them a full range of financing options.” Moreover, longer-term aircraft loans will be more expensive because capital requirements increase as the life of a credit facility extends. After the first two years, risk exposure rises rapidly under Basel III, making financing with terms extending beyond three to five years much less advantageous for the bank due to the greater capital reserves required. Aircraft buyers looking for longer financing terms will have to pay for the privilege.

These factors have already led some European banks to view Basel III as a reason to abandon aircraft finance altogether. On the other hand, financial institutions like Guggenheim Partners and Prudential Capital Group that aren’t banks and aren’t subject to Basel III may actually benefit by having the bank competition tied up in regulatory knots. An opportunity exists here for non-Basel III financiers to grab a greater share of the aircraft finance market. Basel III may also cause smaller, regional banks to be more active in financing aircraft, especially older less-expensive models that are not ­attractive ­collateral for major lenders.

The U.S. implementation of Basel III has not been finalized, but von Weise said that few significant changes to the international strictures are likely, though the U.S. rules may vary in comparison with those in other jurisdictions. North America, the EU and major nations in Asia are expected to begin implementation of Basel III this year.

Aircraft Lease Challenges
Basel III is not the only change in store for aircraft finance. The “lease convergence project”–a joint effort by the Financial Accounting Standards Board and its international counterpart to create uniform standards for lease accounting–will cause aircraft leases to be booked as “right-to-use” assets, with a corresponding liability to make lease payments. These changes could make leases less attractive to companies that have traditionally employed them to keep business jets off the balance sheet. In addition, to the extent that aircraft are treated as assets where the lessee consumes “more than an insignificant portion of the asset,” the new rules may require more of the interest component of the lease payment to be recognized in earlier years–another blow to leases, from an accounting standpoint.

That’s too bad, because otherwise this is a good time to lease a business jet. With the imminent demise of bonus depreciation, the tax benefits of purchasing a factory-new aircraft are less appealing than they have been in years. But financial institutions that offer aircraft leases still have an appetite for depreciation–and for acquiring new aircraft in like-kind exchanges to shield depreciation benefits received in prior years. The result can be a relatively good deal for the lessee, especially for one that can’t use the tax depreciation benefits itself. And in a world where banks are looking for 10 to 20 percent down payments on loan financing, a lease is by definition 100 percent financing (subject to security deposits and the like). No wonder some banks report that aircraft leases represent a growing portion of their aircraft finance portfolio.

Basel III and the changes to lease accounting lie in the future–albeit a not-too-distant one. Meanwhile, aircraft lenders are still struggling with the problem that has haunted them for several years: cash. There’s a surfeit of capital out there looking for a home. An aircraft buyer recently said to me, “Why would I borrow money to buy an aircraft? I have more cash on hand than I know what to do with.”

International Aircraft Finance
The tepid aircraft finance climate in the U.S. has encouraged aircraft financiers in this country to seek out new customers overseas. Many American institutions have been financing aircraft in Europe for years. In fact, some U.S. lenders–CIT and Guggenheim come to mind–specialize in such transactions.

But other international markets–places like China, Russia, Brazil and the Middle East–pose greater challenges for aviation lenders. Jet buyers in these locations frequently have trouble understanding the requirements faced by U.S. banks in making aircraft loans and leases. Dealing with collateral–obtaining, perfecting and enforcing security interests in aircraft–is a major issue, for example. Even if the buyer is a reputable zillionaire, if he resides in a country where foreign investment is risky, it will likely have an ­impact on his ability to obtain financing from U.S. sources.

One prominent financier in the international market is the U.S. Export-Import Bank. Its mission is to provide financing (often in the form of guarantees of loans made by other institutions) to non-U.S. borrowers for the purchase of goods (including airplanes) manufactured in America. The vast ­majority of aircraft financings by the Export-Import Bank are commercial jets, but the Bank is nevertheless active in helping international buyers acquire U.S.-manufactured business jets. Last spring, Congress extended the lease on life of the Bank (a government agency backed by the U.S. government) for an additional three years, also phasing in an opportunity for it to significantly increase its loan exposure limit.

Fractional Shares
Financing the acquisition of fractional business jet shares is an aviation finance backwater. One reason is that lenders find it difficult to obtain meaningful collateral in the case of fractional shares. By definition, a fractional-share participant owns only an undivided partial interest in the aircraft. If the owner defaults, the bank can’t just foreclose on the share (let alone the whole aircraft) and sell it, since there’s no real secondary market for shares. The logical buyer is the fractional program itself, which is in the business of selling more shares, not buying them back and reselling shares already sold.

The original and still the largest fractional program, NetJets, had a relationship for years with a financial institution that provided loans to share purchasers. But in 2010, NetJets announced with much fanfare that it would provide its own financing for share purchasers through its parent company, Berkshire Hathaway. Some form of financing is still available from NetJets, but better deals may be available elsewhere. Flexjet, a NetJets competitor, does not offer financing but will make suggestions about appropriate third-party financial institutions.

Share purchasers who don’t want to write a check for a share should consider leasing instead. If you run the numbers, the lease may be a better deal–keeping in mind that if you purchase a share, you bear the risk that before the program repurchases it, the aircraft will decline in value. That is nearly always the case–and often dramatically so.

Even with stiffer requirements on down payments, amortization, term and aircraft age, business jet finance remains a good deal for good credits. With spreads of between 135 and 250 basis points over 30-day Libor, floating rates are currently below 3 percent and often below 2 percent for investment-grade credits. Fixed rates, though slightly higher, remain popular with buyers who plan to own an aircraft for at least five to seven years. This is still a good time to obtain debt or lease financing.

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““Corporate executives should be your core business . . . You need [account executives who are] comfortable with the kind of boardroom leaders that see Learjet as a tool, not a frivolous extravagance for movie stars and their pets.”
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-Advertising executive Pete Campbell to a Learjet executive on the penultimate episode of TV's Mad Men series, set in 1970.